This Time I’m Not the One Calling It a Subsidy

According to The New York Times and the The Wall Street Journal, the Treasury Department is set to announce its plan for troubled assets early next week. It will include three components. The details aren’t clear since these are anticipatory news stories, but it will be something like this (combining bits of information from the two stories):

The FDIC will create a new entity to buy troubled loans, with the government contributing up to 80% of the capital and the remainder coming from the private sector. The Fed or the FDIC would then provide non-recourse loans* for up to 85% of the total funding (NYT), or guarantees against falling asset values (WSJ), which more or less amount to the same thing.

Treasury will create multiple new investment funds to buy troubled securities, with Treasury contributing 50% of the capital and the rest coming from the private sector. It’s not clear from the news stories, but I think it’s highly likely that these funds will also benefit from either non-recourse loans or asset guarantees.

The Term Asset-Backed Securities Loan Facility (TALF) is a program under which the Fed was already planning to buy up to $1 trillion of newly-issued, asset-backed securities** (backed by car loans, credit card receivables, mortgages, etc.). The idea was to stimulate new lending in these categories. This program will be expanded to allow the Fed to buy “legacy” assets – those issued prior to the crisis. This enables the Fed to buy toxic assets off of bank balance sheets.

Instead of coming up with one plan to buy troubled assets, it looks like the government has come up with three. (As Calculated Risk said, however, ” More approaches doesn’t make a better plan” (emphasis in original).) For now, I think the concerns I expressed last month still hold. If we take as given that the government will only negotiate at arm’s length with the banks (meaning the banks can decide at what price they are willing to sell the assets), then the most important thing is for the plan to work. But it’s not clear if the degree of subsidy offered will be enough to close the gap between what investors are willing to pay and what banks are willing to sell at. Having multiple buyers and using cheap Fed financing will increase the willingness-to-pay for these assets, but we won’t know a priori if it will exceed the reserve price of the sellers.

In the best-case scenario: (a) the government’s willingness to bear most of the risk encourages private investors to bid enough to get the banks to sell; (b) the economy recovers and the assets increase in price from the prices paid; (c) the investment funds pay back the Fed (which makes a small spread between the interest rate and the Fed’s low cost of money); and (d) the government gets some of the upside through its capital investments. (I think the main purpose of that government capital is to deflect the criticism that all of the upside belongs to the private sector.) In the worst-case scenario, the market stays stuck because the banks have unrealistic reserve prices. Perhaps the idea is that, in that case, the TALF will allow the government to (over)pay whatever it takes to bail out the banks.

Most encouragingly, the headline in the Times was “Toxic Asset Plan Foresees Big Subsidies for Investors,” indicating that the mainstream media have figured out the game. (By contrast, the Times headline announcing the bank-friendly terms of the Capital Assistance Program was “Government Offers Details of Bank Stress Test.”) I may soon be out of a job. (Wait a sec, no one is paying me for this . . .)

* A non-recourse loan is made for a particular asset or set of assets. If the borrower fails to pay off the loan, the most the lender can get is the asset (he cannot go after the borrower’s other assets or income streams), so the borrower’s loss is capped at the amount he pays himself. Mortgage loans are non-recourse loans where the borrower’s loss is capped by his down payment.

** Technically, the Fed would loan money to financial institutions and take asset-backed securities as collateral. However, these would be non-recourse loans, so the financial institution could pay off the loan simply by ceding the collateral to the Fed. (It seems to me that because these are loans, if the assets appreciate in value, the financial institutions could choose to pay back the loans and take the collateral back, thereby getting all the upside, but I’m not certain about that.) The TALF will be capitalized by some money (10-20% of the total) coming from Treasury, which will absorb the first losses.

46 responses to “This Time I’m Not the One Calling It a Subsidy”

“Mortgage loans are non-recourse loans where the borrower’s loss is capped by his down payment.” Only in some states, like California. In other states, as in Ohio, the lender can still come after the borrower for any deficiency after a foreclosure sale.

” So, say CITI has a $100 million MBS on its books at $80 million, given the risks and uncertainty, its market price is $30 million, but held to maturity it will yield $50 million. So CITI makes a deal with a hedge fund, which will bid $75 million for the MBS, of which only 3% is its own money, $2.25 million, and out of another branch of CITI, the latter writes a $!0 million CDS on the MBS to the hedge fund for a modest consideration and with cash settlement. SO CITI ends up taking a $5 million write-down and a $5 million CDS loss, the hedge fund ends up making a $2.75 million profit on a $2.25 million investment, about 120%, and the U.S. government ends up with a $20 million loss. Is it really that simple?”

“the TALF will allow the government to (over)pay whatever it takes to bail out the banks.”
Where do you get that idea?
With all three approaches, private investors are in the first loss position, they will decide the price not the government and that rules out overpaying for the assets.
All three approaches are variations of very simple cash-flow CDOs with non-recourse funding by FDIC or the Fed.
You are misrepresenting these plans by claiming the assets are guaranteed, non-recourse is not a guarantee, it merely limits the losses for the investors to 100% of their investment.

Public/Private partnership is just code for: BAD BANKS SELL ASSETS TO THEIR SUBSIDIARIES and AFFILIATES, SUBSIDIZED WITH MORE US COFFERS, AND IF THE PURCHASE GOES BAD, THE ALL AMERICAN CITIZENS WILL LOSE.

If this deceit doesn’t stop, the US will lose all goodwill with the world and our currency will drop like a lead Zepplin–not because of the massive money printing, and unsustainable debt, but because the world can see through the shroud that is placed over the massive fraud that may be in motion, starting with companies being kept alive when they should have failed thanks to free money (subsidized by the world) through the back door of AIG, and the massive campaign that “infusing” money into the banks was the proper use of the TARP 1 money–WHAT A RUSE!!!

The only way this TITANIC lie will change direction, is if the country can maintain sleepless and watchful over what has occurred, until it is corrected by bringing justice back, we are in danger–our national security depends on the citizens keeping this watchful eye over the correction, and seeing it to completion.

Sadly, there is more ahead–if commodity prices rise because of people hording, will the futures contracts fail? Who gets “bailed out then?” This RUSE could never prevent what is happening–the forces behind the deflationary cycles we are in were building for decades, and it is certain tha the precious resources confiscated from our country (via the RUSE) need to be returned or at least what is left.

All of the disaster that we are in could never have been averted by saving the diseased banks–all of that money was put in place to benefit the stakeholders of those banks, not the world. That money may have saved us, thought, from some of the pain that is ahead.

So, my prayer is that this massive dark monster wont be forgotten or swept under the rug by the public, and that justice will be done…investigation, and prosecution of the RUSE architects, will go a long way in making seeds for all of the ideals for which our Republic stands.

if all of the failed institutions were allowed to fail, surely the money that has been GIVEN to the current problem would have been enough to pay unemployment insurance for a very long time to all employees of the failed institutions?

At least this way, the reality of the TOXIC assets/institutions would be dealt with in an honest compassionate, legal (verses the selfdealing RUSE that is in motion now) way because our country could print the money to help the poor executives (and the innocent workers) that lost their jobs due to the failure of their employer’s institution?

I’m no financial wizard (although I do have some financial background), and I didn’t think that Newt Gingrich was a financial guru either, but I saw what looks to me like an excellent article regarding mark to market valuation.

What keeps 2 banks from bidding ‘face value’ for each other’s garbage? Say, C and BAC each use taxpayer money to pay face value for $100Billion the other’s worst toxic assets. They then hand the newly purchased (toxic) assets to the government (now stuck with the bill), but their own balance sheets look much better.
Any ideas?

Say what you want about structured finance and market efficiency, but if you apply it to EXISTING assets, it’s a zero sum game. It does nothing to change the underlying cash flows. It does not create value.

If you assume the treasury is backing the banks, which you have to given the ‘No more Lehmans’ philosophy, this is a game between the banks and the treasury.

If you let another party in and you give them a bet where it is very likely that they make money, they are therefore very likely removing money from the other two parties.

if you are using this to securitize new loan flow it is a different thing entirely. you can make the argument (somewhat damaged now however since structured credit caused this blowup) that securitizing and selling off pieces of the loan increases financing efficiency — and allows more and cheaper and safer credit.

HOWEVER, in this situation the loans are already on the books and they will lose whatever $ they are going to lose. the banks’ losses are (or are close to) spilling over onto the treasury. why in the world would the treasury allow a third party to capture value from this?

This is almost exactly the “trick” I was thinking of, except I had a hedge fund with shares of BAC buying the toxic assets of BAC (so that it’s less scam is less obvious).
Since these programs, if they succeed, will give a huge boost to the banks’ shares, interested investors would first buy a bank’s (eg BAC) shares, then bid highly inflated prices for the toxic assets, then sell the shares once they jump in price, then default on the loan from the government and get away with a nice profit (assuming the gain from the shares offsets the loss of their “down payment” on the loan; I would say that’s a very probable assumption).

“It’s just a scheme to transfer losses from the bank to the taxpayer with an egregious payout to a middleman (SAC) to effectively money launder the transaction.

“You’ve also transmuted a $30mm economic loss into a $36.75mm economic loss because of the laundering. So it’s incredibly inefficient.

“How did fraud and money laundering become the national economic policy of the US?”

The US Treasury is making a mistake if it has not learnt that the public is more discriminating than this.

Bonuses are not the issue at AIG that is causing the media to circle like sharks. They sense it will fail soon… and that story will be far too big to hush up. Therefore, they have set their investigative journalists to find out who knew what and by when.

The same is happening in the UK.

Latest revelations include:

1) the disgraced CEO of RBS, (Sir) Fred Goodwin, did not tell his board he was trading in subprime derivatives;

2) Northern Rock issued a further £800 million in 125% loans after being bailed out by the taxpayer; and,

3) Lord Myners – the Minister charged with getting City institutions to pay all their tax – set up his own tax haven in Bermuda.

It is a dog-eat-dog world out there now. In the row over Fred Goodwin’s pension, Sir Tom McKillop, the former chairman of RBS, has written to the (UK) Treasury select committee’s chairman, insisting that Myners was told the full value of Goodwin’s £703,000-a-year pension. Michael Fallon, deputy chairman of the committee, said: “If the letter contradicts what Lord Myners told the committee then it could be very serious for him.”

I read the above article that tells about how the CEO of USBancorp who announced to a crowd recently that Treasury instructed him to tell the public that the TARP money was for lending but that it wasn’t for lending, it was for acquiring companies to be a part of the Darwinian clensing…….

I think we all remember how we were told that the reason for the 180 degree change from the original plan that two certain government appointed people pushed for because the world was coming to an end and we had to believe that TARP 1 was there to “save the earth as we know it” was because the banks had to be given fresh capital to keep lending flowing in the system…..

If one of our government officials lobbies for policies and even after the policies are implemented in a way that was not offered during the passing of a law to allow power to this person, then that person continues to tell the public that the money appropriated by this law was spent for one purpose, yet that person told the people given the funds appropriated by the law to do something else, wouldn’t that be a betrayal of trust, faith and confidence? And wouldn’t it also look bad if that person had a secret meeting in their office and invited 9 people and insisted on no transcript being made of the meeting? Isn’t there another word for betrayal of thetrust, confidence and faith of the united states of America?

Math wise (assuming cds is sold at the price you quoted): Recovery is 50% so payoff on cds for 10 mil notional principle will be just 5 mil usd.
So hedge fund will lose 2.25 mil usd (assuming they absorb losses on investment first and it is not shared between them and government) + 1 mil usd it pays for cds = 3.25 mil total. It will get payoff of 5 mil usd from cds protection so total gain of 1.75 mil on 3.25 mil investment.

However that is assuming that bonds default with recovery of 50 cents on a dollar. If they default with recovery of 70 cents on the dollar math is different: If private investor is first to absorb loses it will still take a hit of 2.25 on bonds and pay 1 for cds and it will recover only 3 mil this time for a loss of 0.25 mil. Basically, in the case you mentioned, the lower recovery rate the better for private investor (and the worse for the taxpayer and citi)

Going back to the first assumption of 50% recovery: Citi loses 4 mil on cds (5-1). It writes additional 5 since it sold for 75 something it carries at 80 right now. So total loss of 9 mil.

taxpayer loses 75-2.25-50 = 22.75. This is assuming that private investor absorbs all initial loses up to full amount he invested.

This way everything adds up: Total loss was supposed to be 30 mil (80-50) and was supposed to be all absorbed by Citi. This way Citi absorbs 9 mil, tax payer absorbs 22.75 mil for total of 31.75 mil of losses and then u subtract 1.75 mil that private investor gets to get 30 mil.

Note however that even this is not risk free for private investor since there is counterparty with respect to Citi issuing CDS. So unless CDS is guaranteed by government it is not risk free profit for privite investor.

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There is also problem with the assumption that Citi will sell you CDS protection on 10 million usd notional principal of those bonds for 1 million usd.
There is arbitrage triangle between risk free bond, risky bond and its CDS protection, you can construct any of them out of the other two (assuming cds protection is done by default free party). In this case cds protection is too cheap, it should be spread between yield of those bonds and risk free yield on comparable bond issued by risk free party. In absolute terms it should be about 7 mil on 10 mil principal. If it is 1mil as you quote, one could buy 1 mil cds protection on 10 mil notional principle of those bonds and, at the same time, he could buy for 3 mil amount of those bonds that has notional principle of 10 mil. Thus for a price of 4 mil he would obtain basically 10 mil of risk free bonds (assuming citi does not default on cds protection).

However that correct pricing holds for regular free market, in this special case of government interference into citi may be forced to do packaged deal like this so that cds is basically used just to obscure what is going on making it more difficult for public to grasp that they are being robbed.

I am mildly amused that credit card receivables qualify for the TALF. While I realize that they are worth something, there is no underlying asset of any value to support them. Mortgages, credit cards… what’s the difference… maybe that’s why we got into this mess in the first place.

Charged off credit card receivables have historically traded in the Bad Paper markets at between one-half to four cents on the dollar. They’ve been a fairly known quantity, but this other heterogenous stuff is proving problematic to valuate these days.

It’s bad out there, worse than the administration wants us to realize. Look at WAMU. JP Morgan Chase basically got them for about 1.6 cents on the dollar — i.e., divide the $1.9 billion purchase price by the reported net “assets” at the time). That’s an aggregate rule of thumb for the “quality” level of these “assets.”

According to this plan, is it possible for an investor to make profit _AND_ for the taxpayer still take big losses?

For example, let’s say there’s an asset yielding $100 a year. The investor pays $50 for it, and the government loans $1600 (3 to 97 ratio) to the investor. The investor can hold the vehicle for 1 year, realizes the asset will not yield much in its second year –maybe due to more foreclosures — and just returns the “keys” to the government. Since it’s non-recourse no need to pay the full $1600. The government would then sell the asset in the market for a lot less than $1600, let’s say for $600. So that’d be a $50 profit for the investor and $1000 loss for the taxpayer. Is this logic correct?

OK, I have a question for Mr Geithner and team… If these toxic assets are worth more than what everyone says they are (mark to market), then why does anyone need to buy them and why does the government need to finance it? I can understand maybe paying high prices in the firestorm of the panic to support the asset prices and try to avert or end a panic, but it’s been 3 or 4 months since then. It would seem that now that things have stabilized that all you’d need to do is open the banks books up and “prove” how good these assets are. If shedding light on the issues doesn’t makes these assets more valuable, then what’s the logic in overpaying for them?

To follow up on Adam’s comment above, this idea that we need to “get back to normal” is becoming more and more absurd. In September/October we had a panic mindset, and there is an excuse for sloppy plans in that environment. I’ll cut them slack (a little) for that. But now with a few months for thought, the reality has become increasingly clear. I’m not trained in finance, but what do people think of this simplistic review of what I have seen written here and in other blogs during this year?: we had a negative savings rate for years, meaning people were spending more than we were earning on all sorts of assets (homes being the posterchild). We are now headed back to a positive savings rate (good news long term), and that means by definition, people cannot afford to spend the money we were spending when we were borrowing it all. In other words, the money simply isn’t there to return to “normal”, or put yet another way, it was never normal to begin with. All this indicates that the market price on these investments is correct, and the banks are dreaming if they think the prices are anywhere near what they hold on their books. Meanwhile, the treasury is being intensely naive or criminally stupid or both in putting taxpayer money into schemes based on prices rising again. Let the banks go into receivership and admit that the fundamentals were wrong all along. We keep avoiding this, and it keeps getting more painful by the day.

This is what I have absorbed from religiously reading this and a couple of other blogs on the subject for the past couple of months. Thank you Simon and James (and Paul Krugman and others and all those whose comments are on these boards, where I’ve learned a lot) for great insights into these issues.

If auction prices come in well below the ludicrous levels at which they are currently marked,the whole process will come to a screeching halt to avoid another round of huge write-downs. But it seems impossible in the current environment for the Administration to go back to Congress for additional funds to buy these assets at above market prices. The current populist rage we are seeing may then have some value by preventing yet another unearned subsidy. But the question then is whether the Administration will waste more time by tweaking the same ill-conceived plan, or actually come to grips with what needs to be done – nationalization, stripping of bad assets and a quick resale.

1. As far as I can tell, TALF does not have a private component – it is Treasury capital plus Fed loans. So the government controls the price.

2. Limiting losses to 100% of your investment is a guarantee. It gives you unlimited and juiced-up upside, due to the leverage, without the risk of going negative, which you ordinarily get with leverage.

My paper “The Put Problem with Buying Toxic Assets” at http://ssrn.com/abstract=1343625 suggests that the gap between the price at which banks are willing to sell toxic assets and the price at which the private sector is willing to buy toxic assets may be large. The bid-ask spread will be larger for banks that are more insolvent. It will also be larger for banks that have more distressed or volatile toxic assets. My research shows that it is much better to buy toxic assets from troubled banks in receivership than before their assets are written down.

My paper “The Put Problem with Buying Toxic Assets” at http://ssrn.com/abstract=1343625 suggests that the gap between the price at which banks are willing to sell toxic assets and the price at which the private sector is willing to buy toxic assets may be large. The bid-ask spread will be larger for banks that are more insolvent. It will also be larger for banks that have more distressed or volatile toxic assets. My research shows that it is much better to buy toxic assets from troubled banks in receivership than before their assets are written down.

The Congressional Oversight Panel already found that treasury paid 1.33% for the assets that were purchased in the fall, and it seems to becoming apparent to the public that receivership would have been fair for AIG, instead of the current approach that allows tax payer money is laundered to counterparties. For some reason, this is just accepted as Ok. We are like mice on a wheel with no where to go, while the looting continues with a new names– public/private partnership with many names is like a cancer spreading out and making new blood vessels to suck the host dry.

I take a pragmatic view to the current debate. To be fair, I think we should all agree that the question of nationalization vs. not nationalization is not obvious. There are many heavy weights in business, academia and government debating this. To be honest, anyone who feels this stuff is obvious probably didn’t listen enough to the other side’s argument.

With the above in mind, no matter which solutions we go with there is significant chance that the solution doesn’t work well. However, we do know that once we go down the nationalization route, there is no recourse if it blows up. With the Geitner plan, we can try again with nationalization.

To my point above, one can argue that we’ve successfully employed nationalization in the past with insolvent banks in developing countries and with Japan in the 90s. Here is why I think it is a fallacy.

To begin with, it is not clear that most banks are really insolvent (including Citibank). Here are some very good analysis and supporting information.

The view that most US banks have significant positive cash flow and will recover on their own in a few years is collaborated by Warren Buffet during his CNBC interview:

“I mean, the banks are getting their money very cheaply, deposits are coming in, spreads have never been wider, all the new business they’re doing is terrific. They will earn their way out of it, in most cases, overwhelming number of cases.” – Warrant Buffet

Banks’ positive cash flow is also supported by today’s steep interest rate yield spread. This explains why many banks are so bold as to declare they don’t need bail out from the government.

Also keep in mind that US has always had more stringent banking requirement than most of the world. I don’t think a failing bank in a developing country or even a failing Japanese bank in the 90s can compare to the situation most US banks are in today. However, I am not an authority here and I stand to be corrected.

Will cleaning up banks balance sheet improve lending? The obvious reason banks are not lending is they are in poor financial health.

However, there is another very important reason and that is the falling asset price. Banks loans are being collateralized by falling assets; as such banks has to pass on the risk to the borrower in higher cost and more stringent lending standards. The Fed’s action last week and Geitner’s plan all provide direct support for asset price.

I just heard someone said that Elizabeth Warren, chair of the Congressional Oversight Panel, went on TV and said, please someone, anyone give us a plan.

I am sure you both would get together the rationale for all of the ideas that are fair, and balanced and designed to “do no harm” yet also, account for the fact that people/companies did take risks and they lost their bet, and the taxpayer doesn’t need to pay the risktakers bill….

This is a tall order request, but would you please consider a huge dissertation to offer Elizabeth Warren which not only offers a plan on every angle from what to do about the banking crisis, to what needs to be outlawed and changed adn why, and with each point on your list, please adress the very crafty, clever people who will want their agenda and free money plans to continue forward? If you address all issues on the basis of knowing who the critics are, then it will go a long way in helping the plan have credibility.

In the fall of 2007, i became completely frustrated that i wasnt a practicing CPA, Lawyer and economist because the proper, fair, and just way to approach our banking and investment banking problems rests on a fair, just, non-self dealing solution which involves extreme understanding of all of these disciplines.

I see what has happened is our country has become a GROUPTHINKTHINKTANK where very selfdealing plans have been executed, and now, we are at the TIPPING POINT (to use your term), because our country’s solvency, our currency’s reputaion and indeed our national security depends on a justice being done in retrospect and going forward.

Anyone who wants to say we have to move forward is forclosing upon the United States citizens’ ability to trust because MUCH was done over the last year, that was self-dealing, and this has to stop….even the public/private partnership is another scandle–money needs to be preserved for the real disasters that are going to occur from our country being weakened by the power of the criminal irresponsiblity that has been allowed to seem like business (financial) as usual.

It may take a CPA/LAWYER/ECONOMIST to articulate what is wrong, the gut of the people will always sense the truth, and they always know something is wrong. OUT GUT IS SO SICK FROM ALL OF THE SELFDEALING THAT IT MAY NEVER RECOVER.

There has to be a cure to the sick gut, and the cure comes from goodness, a plan designed by someone or a group of people ) who must be good in every way…i see goodness in your views although i know that your critics want to say you are acting on conflicts…but anyone can do that, and i trust that you are not doing that. The shareholders of the banks and other companies that led these companies into the EVIL HELLISH CESSPOOL should look to Sarbanes-Oxley, and their own legal action to correct their damages. By the government covering up the whole mess and passing money t0 the organizations that have greatly violated their responsibilities towards the shareholders, it has thwarted any kind of process that our legal system could have allowed shareholders to have–like a bait and switch on the conciousness of the shareholders.

Please as part of your plan, offer options for the shareholders as well and leave as few stones unturned as possible.

I am so sorry to ask this of you both, but i believe that the two of you, with your colleagues may actually save our country from what could happen if the universally destructive train that is rolling doesn’t stop.

Excellent post, Boris. “Normal” was never normal, and there’s no freakin’ way we’ll ever go back to that. But nobody wants to admit it, it’s too painful.

Re Treasury, I think they’re neither stupid nor naive.
If you start from the premise that Treasury is working in the interest of the American people/taxpayer, then yeah, the only explanation for their actions is stupidity/naiveté.
But if you start from the premise that the boys and girls currently at Treasury are the same ones who were yesterday at these private financial institutions and that they’re intimately linked with the boys and girls currently in the private sector and that they’re all part of one big family, then it becomes immediately obvious why some members of the family won’t do anything to hurt the other members of the family. It’s not stupidity, it’s self interest.

“As far as I can tell, TALF does not have a private component”
Wrong, TALF does have a private component, it’s called “haircut”, that’s what investors have to fund themselves to access fed money, that’s equivalent to margin or equity and is 100% at risk until the loan maturity as the non-recourse clause kicks in only then.
This is my main complaint about your blog, you make wild claims and have NOT read the FAQs.
here it is: